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Thursday, March 28, 2013

Catalysts for Merger

We've talked before of motives for merger. This time let's talk about what causes an entire industry to
suddenly be the target of acquisition attempts or similarly why an industry
suddenly starts making bids for other firms.

Think of an industry where no firm has been
targeted for acquisition and imagine that this situation has prevailed for some
time, say at least a year. Metaphorically, the waters are still, the pond
is flat, with no acquisition activity causing disruption. The first bid
for a firm in this industry is going to cause waves, possibly large waves, in
this industry - like a rock thrown in the middle of the pond.

What causes this sudden activity?
Presumably some managerial team has decided that the assets of the target
firm are worth more to this team than their current market value. Hence a
bid takes place. Will this signal other bids in the industry?
Perhaps. In another post we'll talk about merger waves. For
now, let's assume that the first firm to be targeted does indeed signal the
possibility of other bids. What are the reasons for this sudden activity?

The reasons are that something has occurred to
cause the value of the target firm to increase in the view of the bidder.
What causes this shift? In terms of the present value equation some
catalyst must have caused an increase in the estimated cash flows or a decrease
in the discount rate. Either (or both) of these will increase value.

As one example, there were a multitude of oil
mergers in the 1980s. One reason is that exploration and development
became a value-losing proposition. Why did this occur? Because the
price of oil (a fundamental component of cash flows) dropped from over $40 a
barrel to $10 a barrel and simultaneously, interest rates rose from single
digits to double digits. As a consequence, the present value changed from a positive cash flow to a loss for each
barrel discovered. For Gulf Oil, the present value impact was about $50. per share.
A popular Harvard case makes these points and others
in explaining how Gulf Oil could be trading for $38 today and receive a bid of
$80. per share tomorrow.

So what are these shocks, these catalysts? Common catalysts include: shifts in regulation, shifts in consumer
tastes, competition from unexpected sources, changes in the factors of production and changes in technology.

Shifts in regulation cause firms to adjust their
behavior. New regulation increases the costs of operating a firm.
Reduced regulation creates new opportunities. Both types of shifts
can make it more profitable for firms to combine. In some cases firms
reduce costs through economies of scale. In other cases, firms are able
to exploit synergies in situations previously blocked by regulation. A
good example is the banking industry where regulations prohibited growth in a
(new) state unless a bank already had a presence in that state. One way
to establish a presence was merger with an existing bank.

When consumer tastes shift, so do the estimates
of future cash flows. Investments that previously seemed unattractive (or
attractive) are reversed. As as result, targets find it beneficial to
merge with other firms to exploit new synergies or merge as an attempt to
reduce over-capacity in the industry. Firms that fail to adjust to shifts in
tastes (e.g. Chrysler) are forced to merge to avoid bankruptcy (General
Motors). In addition to an industry example like automobile manufacturing, one can think of company specific examples like Dell or Hewlett Packard or Yahoo. All
were dominate within their industry until they failed to keep up with changing
times.

Changes in the factor of production can include
changes in the cost of supplies, or changes in the cost of wages, or changes in
other elements used in producing or delivering products and services. As one example, some products depend more heavily on oil in their manufacture. As the price of oil changes, so do the costs of these products. In
many cases, mergers occur to capitalize on these changes. Vertical
mergers will occur as bidders seek to control supply, reducing uncertainties
and costs in the process. Horizontal mergers will occur to erase overcapacity and develop economies of scale

Competition from unexpected sources occurs as new competitors enter what was once a protected business environment. This could be accompanied by a shift in regulation like increased interstate banking or from the entry of foreign companies into what was primarily a domestic market. It also happens when products are suddenly put to additional uses that infringe on new territory. For examples, think of how the various applications for the cell phone have eroded traditional markets. Garmin once profited by selling stand alone GPS units, now a smart phone application does the same thing.

Changes in technology cause firms to adapt or become
obsolete. Polaroid and Kodak are good examples. Banking is facing overcapacity with the advent of the internet. I sometimes
challenge executives to think of the new products and services that have
existed only in their lifetime. They mention Personal Computers, the
Internet, Digital Cameras, and even things like Rock and Roll and Viagra!
Each new product and each new technology is a catalyst for change and a
potential force for mergers in a particular industry. (See our related
posts on Do Unto Yourself and Anticipation, Acquisitions and Bidder Returns as
well as posts on Dell and HP.)

Obviously, many of these catalysts are interrelated. New smartphone applications that reveal calorie counts on specific food items can lead to shifts in consumer tastes. Similarly, scanners on smart phones may lead customers to buy online, a new source of competition.

Any of these or other catalysts can lead to merger either for a particular firm or for an entire industry. We'll follow up down the road with a related
post on merger waves.

1 comment:

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About MergerProf

In addition to their day jobs, Joe and Ralph teach acquisition finance at the Amsterdam Institute of Finance. This blog was created in the summer of 2012 as a tool for those interested in acquisition finance and related material. Admittedly, we define related material broadly to include mergers, private equity, banking, governance, deal making and, well, finance in general. We hope you will enjoy and contribute, critiquing, expanding and providing your own examples related to the posts. We encourage you to join us in this adventure and, for some of you, to see you in Amsterdam, New York or Philadelphia.